BFE 420 Portfolio Engineering Lecture 6

Ms P. Mawire

Harare Institute of Technology

pmawire@hit.ac.zw

March 13, 2019

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Overview

1 Equity portfolio management Strategies

2 Experience-based Approaches

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WAKE UP

Johnny’s mother had three children.The first child

is named April. The second child was named May
. What was the third child’s name?

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Active strategies

Attempt to ‘beat the market’

Form portfolio that can produce actual returns in excess of
risk-adjusted expected returns
Difference between actual and expected returns is called portfolio’s
alpha.
Alpha is the excess return that the portfolio generated over what was
expected

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Passive strategies

Portfolio return will track those of a benchmark index over time.

Indexing

No attempt to generate alpha

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Index Portfolio construction techniques

There are three basic techniques for constructing a passive index

portfolio
Full replication
Sampling
Quadratic optimization or programming.

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Full replication

Equity indexing is the most popular form of passive investment,

aiming to replicate the risk and return characteristics of a benchmark,
usually a wide stock market index.
All the securities in the index are purchased in proportion to their
weights in the index.
This technique helps ensure close tracking, but it may be suboptimal .
Need to buy many securities will increase transaction costs that will
detract from performance.
Attempting to fully replicate an index containing a large proportion of
illiquid stocks will usually result in an index portfolio that
underperforms the index.
This phenomenon occurs because indices do not have to bear
transaction costs

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Sampling technique

Using stratified sampling, a portfolio manager divides the index along

a number of dimensions e.g., market capitalization, industry, value,
and growth, creating multidimensional cells.

Each index stock is placed into the cell that best describes it. The
manager would then build a portfolio by selecting a random sample of
stocks from each cell and ensuring that the sum of the weights of the
stocks purchased from each cell corresponds to the cell’s weight in
the index.

Buys a representative sample of stocks in the benchmark index

according to their weights in the index

Fewer stocks means lower commissions

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Quadratic Optimization (or programming techniques)

Another technique commonly used to build portfolios containing only

a subset of an index’s stocks is optimization. Optimization is a
mathematical approach to index fund construction involving the use
of:

A multi-factor risk model, against which the risk exposures of the

index and individual securities are measured.

An objective function that specifies that securities be held in

proportions that minimize expected tracking risk relative to the index
subject to appropriate constraints.

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Quadratic Optimization (or programming techniques)

The multi-factor model might include factors such as market

capitalization, beta, and industry membership, as well as
macroeconomic factors such as interest rate levels.

Historical information on price changes and correlations between

securities are input into a computer program that determines the
composition of a portfolio that will minimize tracking error with the
benchmark

Relies on historical correlations, which may change over time, leading

to failure to track the index

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Suitable technique

Each of the techniques for building an index portfolio has strengths

and weaknesses.
Generally, when the index contains highly liquid stocks, full replication
is usually the preferred index construction method.
Apart from minimizing tracking risk, a full replication portfolio has
the advantage of being self-rebalancing (given that it is based on a
value- or float-weighted index). for smaller-cap companies, and
replication may not be the most cost effective choice given the costs
of transacting in small-cap issues.
Stratified sampling and optimization are preferred when a portfolio
manager wishes to track an index containing a large number of
stocks, particularly stocks that are more difficult and costly to trade.

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 The End

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